"Britain cannot have its cake and eat it over Brexit negotiations.”
Comments such as this from the Prime Minister of Luxembourg at the height of political tensions following the EU referendum have, perhaps unsurprisingly, become synonymous with the Brexit debate since 23 June. But with the triggering of Article 50 just around the corner, it is surely high time for both sides to stop the political back biting and consider some cold hard truths.
And nowhere is a good dose of reality needed more than the current debate surrounding whether London should remain the central hub for Eurozone clearing. While any shift in operations would clearly be a blow to the City, is it really feasible for Europe to seamlessly become the new kings of clearing given the huge costs and complexity involved?
According to a recent study by the International Regulatory Strategy Group (IRSG), a lack of clarity over post-Brexit clearing will lead to higher costs and decreased growth prospects for banks operating inside the EU. And let’s face it, with Europe facing a wave of populist revolts, no member state wants to commit to long-term capital expenditure projects with so much political uncertainty in the air.
London’s current dominance means that any move in operations to mainland Europe would be extremely expensive, and would be far from easy to implement. To put this into context, around €1 trillion is exchanged in the City every day. When it comes to clearing derivative contracts, such as interest rate swaps, options and other exotic products, the UK is the market leader in euro-denominated transactions, with a daily turnover of over €900bn euros. That’s a staggering 75 per cent of all euro-denominated derivatives transacted in London, according to the Bank for International Settlements.
With these figures in mind, it is hard to envisage a speedy and cost efficient rerouting of clearing business, especially if a transitional deal is not reached. Unless an extensive period is factored in to gradually shift clearing operations beyond the two-year Lisbon Treaty timetable, it would be an uphill task to replicate the reliable and sophisticated infrastructure currently underpinning London’s clearing houses.
Take the underlying network connectivity that has become an integral part of clearing. The settlement of exchange-traded derivatives, where gains and losses on every contract are calculated and reported on a daily basis, would be severely affected by a sudden shift in operations.
Any disruption to the links connecting clearing services could lead to a trading firm incurring losses that wipe out the initial upfront margin. In this situation, the firm would have to restore the capital quickly, or risk its trading position being sold off. With these risks, heightened by the vast volume of trades cleared daily, reliable and stable connectivity to clearing services is fundamental.
On top of this, with firms in the middle of adjusting their business models to fall in line with regulation such as MiFID II, which is forcing all standardised derivatives contracts onto exchanges, the last thing the industry needs is a lack of clarity on where and when to relocate operations.
Despite no clear timescales, clearing houses are pressing ahead by reviewing their existing business to ensure operations run smoothly. Quite apart from the risk element, clearing is a fiercely competitive environment. And with the volumes continuing to increase, clearing houses will be jostling for position. With this in mind, the ability to maintain a consistent customer experience if and when they relocate may prove make or break for some.
Beyond timescales and reviewing operational models, there are wider geographical implications at play here. Financial institutions with major global footprints benefit greatly from focusing their clearing efforts across a few locations, mainly because it reduces the running costs of their clients’ derivatives portfolios. As tempting as it may be for European and UK politicians to make life as difficult as possible for each other, as soon as Theresa May triggers the formal renegotiation starting gun, the point-scoring needs to stop, and a concise transitional plan needs to be agreed.
The City’s stranglehold on clearing has been in place for so long now that any sudden move in operations based on politics rather than pragmatism will only serve to hurt both sides. The clearing cake will be one of the centre-pieces up for grabs in the renegotiation. However, with the costs and complexity involved, Europe needs to ensure it doesn’t bite off more than it can chew. After all, whoever takes the spoils, global banks will only settle for one outcome – seamless and reliable access to clearing services.